Xero: Lemming bubble or hero?

20:53, Jul 23 2012

We shouldn't poke fun at lemmings. Contrary to mythology, they are not prone to mass self- destruction. They are merely, on occasion, collectively unwise.

They are in this respect just like us. If they were less small and furry, and had a functioning financial system, lemmings would probably invest in tulips, dotcom companies or real estate in the Isthmus of Darien, Panama.

So, would lemmings want to buy shares in a company valued at $500 million if it is yet to make a profit, has no prospect of doing so in the next few years, and reports revenue of less than $20m?

Unfortunately, no lemmings could be reached for comment, but clearly quite a few investors in software company Xero would answer "yes".

A month ago Xero's market value topped $500m after a meteoric rise of more than 100 per cent over 12 months - and the shares kept rising. Last week it was worth a remarkable $600m, having gained more than 20 per cent in just a month.

Seeing the stock hit $5.70 a share, one senior analyst was moved to tell me its value was "just insane".


What we have here is an interesting investing conundrum. When a company is producing profits and dividends there are certain processes you can use to figure out how much it might be worth. For a company like Xero, whose profits are potential rather than actual, estimating its value is more art than science.

Hence, when investors start to pile into Xero shares, the line marking the crossover from growth stock to lemming bubble is vague indeed.

It doesn't help that 81 per cent of the shares are held by just 56 shareholders, leaving the market price driven by small retail trades.

Analysts covering Xero are thin on the ground, but two have had a stab at forming a view.

Peter Ball at Craigs Investment Partners put out a research note on July 12 suggesting it was "expensive at its current share price" of $5.06.

Fraser Hunter and Andrew Harvey-Green at Forsyth Barr said on May 25, with the price at $4.20, "while we believe XRO has positioned itself well for success, it is still early days and we believe the market is already factoring a high chance of success and overlooking the downside risks."

They recommended investors reduce their holdings.

The reason they say "reduce" rather than "sell" is that Xero is a genuinely exciting company with a potentially market-leading product on a global scale. Investors can take profits and still have some skin in the game.

You can't really evaluate what makes Xero different unless you use its products, but even a non- user can see why they might be attractive.

Xero's big thing is accounting software for small businesses, which are the most numerous kind of businesses in New Zealand and overseas. As well as focusing on ease of use, Xero sells its software as a low-cost monthly subscription to a web-based service.

There are several advantages in this model. For example, once customers are established, revenues are less volatile than selling software in a box. Customers can access functionality anywhere and share data with their accountants easily, and they don't have to worry about upgrades.

Xero isn't unique in offering accounting software as a service, but its big established rivals, such as MYOB, Sage and Intuit are yet to embrace it fully.

In summary, Xero reckons it can outmanoeuvre the competition with sheer innovation and operational excellence, becoming the small business software of choice in New Zealand, Australia, Britain and the US.

No wonder some investors are star-struck.

But is it, right now, worth $600m?

In 2009, Xero's Australian rival MYOB, then a listed company, was subject to a hostile takeover bid from a consortium led by private equity firm Archer Capital. The bid was successful and Archer acquired MYOB for A$560m.

At the time, MYOB had revenue of about A$173m and earnings before interest, tax, depreciation and amortisation of A$55m. It was also growing fast - last August an Australian Financial Review report said its ebitda was A$100m on revenue of A$200m.

By comparison, Xero's revenue for the year to March was $19.4m, producing a loss of $7.9m. In a recent presentation it said it had 78,000 customers, compared to 1 million for MYOB.

In 2009 Archer's bid was seen by MYOB's board as far too low and succeeded only because some shareholders were eager to cash up. The directors' view was probably vindicated when Archer sold MYOB to Bain Capital - now famous as the alma mater of US presidential hopeful Mitt Romney - for A$1.2 billion 11 months ago.

The MYOB episode underlines how valuations can change hugely in a relatively short time and led to concerns in Australia that the listed market was undervaluing local software companies.

Here in New Zealand we should obviously avoid making the same mistake, but if I had $600m I doubt I'd spend it all on Xero today.

Tim Hunter is deputy editor of the Fairfax Business Bureau.


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